Thoughts from Dave Mead and discussion about issues and concerns for Small and Mid-size Businesses. Some discussion topics will include strategic planning and execution, improving profitability and cash flow, maximizing value for exit.

Wednesday, June 25, 2014

[Editor's note: During the downturn
that started in late 2007, most companies did an excellent job of
reducing expenses and improving cash flow. However, we have observed in
the last 18 months a disturbing trend. In the drive to improve the top
line, companies are beginning to lose focus on the importance of
"profitable growth." We decided to run a series on profitable customer
growth. In Part 1 we
outlined how a few customers can drive net profitability. This is Part 2
- a process to improve profitability. We hope you find it useful. -DPM]

Improving Your Business: One Profitable Customer at a Time

Part 2 - A process to improve profitability

Many
managers seem to rely on intuition to determine if a customer is
profitable or not. Sometimes the intuition is correct and sometimes it
is not. Besides one's intuition not being correct, relying on intuition
to determine customer profitability confuses the organization. Why?
One's intuition varies greatly depending upon position in the
organization and how the relationship is viewed. For example, for the
sales vice president trying to make a sales goal, that unprofitable
customer can be very attractive. For the technical director who must
provide support to that same customer, the relationship appears very
unappealing. There must be a process for assessing customer
profitability and it needs to be used consistently throughout the
organization. Here are some suggestions:

Define your core strengths

Customer profitability
centers on what a company does well and then matches these strengths
with a customer group which values them. BMW is known for its ability to
design and produce high quality cars with great road handling
characteristics. As an organization, it understands this strength and
seeks to cater to customers who seek cars that have excellent handling
characteristics.

Take a hard look at your organization. What
does it do exceptionally well? What differentiates it in the market? Ask
this question of people throughout the organization. The responses may
differ based upon who you talk to but you should hear some consistency
about the core strengths of the business. Expand your analysis beyond
internal perceptions; ask your better customers why they buy from your
company. This is the first step in identifying where your organization
needs to focus its efforts.

Study and Determine the characteristics of profitable and unprofitable customers.

Take
the top 10% - your most profitable customers. Do these customers have
similar characteristics (e.g., technical requirements, order size,
etc.)? What types of products and services do they purchase? Are these
customers more profitable because they are more loyal (sales and
marketing expenses are less)? How do the characteristics of this
customer group align with your company's strengths? You will likely see
an alignment if you look closely enough.

We have worked with a
company in the software industry with a long history of profitable
growth. Its projects are typically long-term in nature and management
takes customer selection very seriously. The company's disciplined
customization and project management process includes a great deal of
client collaboration. At the heart of the process is developing a good
understanding of project objectives and the customer's customer. Key to
the company's long success has been selecting clients whose approach
fits the process and are good candidates for repeat business. The
company avoids single project clients shopping solely based on price,
since this approach does not fit well with their collaborative process.

After you have looked at your top customer group, repeat the process
with less profitable customers. What are the common characteristics of
these customers? They are likely very different than those more
profitable customers.

Establish guidelines for evaluating customers.

If
you wish to move beyond simply talking about customer profitability,
you must establish guidelines for evaluating customers. Guidelines could
include:

order size (orders in quantities the company is set up to handle)

product
mix (customer is not just cherry picking to get the lowest priced
products or services. This is important if you offer loss leader
products)

technical support requirements (can the customer be effectively served?)

growth potential (does this customer have the potential to grow?)

how long will you let a customer receive special treatment on "potential" alone

As
you can see from the above list, it is a combination of financial
measures, buying practices and long-term potential. Do not worry about
developing the "perfect" measure. The most important thing is to develop
consistent parameters that make sense for your business. If you apply
these criteria consistently, you will see a clear segmentation between
your best and worst customer relationships.

Taking Action - One Customer at a Time

Now
that you have defined the profile and characteristics of profitable
customer relationships, begin putting the evaluation process into
action. One of the first places to start is with prospective customers.
Focus your energies and sales efforts on prospects consistent with your
evaluation criteria. Prospects that do not fit most of your evaluation
criteria are not likely to develop into long-term profitable customers.
Make sure your sales team has a clear understanding of the types of
prospects you are targeting.

As you attempt to improve
profitability, focus on your top quartile relationships as these
customers often represent one of your best growth opportunities. Map out
clear strategies for retaining and growing these relationships. Learn
more about your customers' businesses and how they serve their
customers. This collaboration can uncover new opportunities and help you
forge stronger relationships. As you eliminate the unprofitable
relationships, this frees up time and other resources for your more
profitable customers. This is an important principle of executing a
successful fewer and deeper strategy.

Don't fire unprofitable customers. Modify the unprofitable behavior.

What can you do about unprofitable relationships? Be aggressive
about changing those unprofitable relationships. Make certain the sales
team understands that the customer must become more profitable within a
given time.

Don't just fire customers, however. Often, it is we, the sellers, who
have encouraged or permitted "unprofitable behavior." These customers
may offer profit potential - particularly if they fit many of your
evaluation criteria. Look for differences in how you are serving these
customers versus your more profitable segment.

You
may be overlooking product or service opportunities that could enhance
profitability, or you may be making inaccurate assumptions about client
needs. One client's management team believed it was obligated to supply
certain customers with unprofitable commodity products in order to sell
more profitable, high margin product lines. Interviews with customers
revealed otherwise. There were many alternatives for procuring commodity
products and customers were primarily interested in the more
innovative, higher value product lines. A subsequent change in product
mix has boosted profitability significantly.

If
a path to profitability cannot be found, use pricing as a way out of a
relationship. Be sure to provide recommendations for alternative
vendors. You never know when an unattractive customer can change and
become desirable.

Many successful middle-market companies take
pride in their premium, high touch service levels. Each customer usually
receives the same products, services, and delivery regardless of
profitability. This approach, combined with the size or buying practices
of some customers, makes some relationships appear hopeless. If there
is no clear path to profitability under your current product and
services umbrella, consider offering alternative services for these
customers. This may be a particularly viable alternative if you have a
large segment of unprofitable customers with similar needs. Depending on
your business, alternative services may entail different methods of
selling (e.g. inside sales vs. more costly face-to-face), a different
scope of service or different pricing structures. These changes can
completely change the profitability picture for these customer
relationships.

_______________________

The Mead Consulting Group has been helping clients identify and improve customer net profitability
and execute strategies that drive profitable growth. For a free
consultation, contact me at meaddp@meadconsultinggroup.com or
(303)660-8135

Tuesday, June 3, 2014

[Editor's note: During
the downturn that started in late 2007, most companies did an excellent job of
reducing expenses and improving cash flow. However, we have observed in the
last 18 months a disturbing trend. In the drive to improve the top line, companies
are beginning to lose focus on the importance of "profitable growth."
We decided to run a series on profitable customer growth. We hope you find it
useful. -DPM]

Improving Your
Business: One Profitable Customer at a Time

Part 1 - A Few good
customers can drive your growth

Over the
last few years there has been increased focus on the strategy of "fewer
and deeper" as a strategy for growth. The logic of this strategy is
straightforward-focus your resources on a fewer number of customers with whom
you can have a deeper relationship and this will cause increased growth. Please
note that we are not advocating extreme customer concentration, as this leads
to excessive risk and can be a discounter of value when a business looks to
sell. In this series of articles, we will address how to improve business
results dramatically by gaining a deeper understanding of most profitable
customers.

Selecting the Right
Customers

In most
businesses, a relatively small number of customers generate the bulk of the
revenue (typically 20% of customers generate as much as 80% of revenue). One
recent client derived 98% of their revenue from only 25% of their customers.
This client assumed that the remaining 75% of the clients represent high margin
business and thus, a greater share of profitability. Unfortunately, for this
client and many similar companies, this usually is not the case. According to
this study of retail banking performed by KPMG, 140 to 170% of profits can come
from 20% of customers while 80% of losses can be attributed to only 20% of
customers.

Research
completed over the past fifteen years by The Mead Consulting Group, with data
from over 1900 companies ranging from $4 Million to over $5 Billion in revenue,
shows a similar pattern. The Table below illustrates an extreme example. In one
company as few as 2% of the customers generated 800% of the profits, while the
losses are generated by fewer than 10% of the customers. The balance of the 88%
of the customers, remaining in this example, is about breakeven.

Tier

# Customers

% of Total Customers

Net Profits (Loss)

% of Net Profits (Loss)

Tier 1

19

2.0%

$8,648,185

801.5%

Tier 2

845

88.1%

($43,160)

(4.0%)

Tier 3

95

9.9%

($7,526,025)

(697.5%)

Total

959

100.0%

$1,079,000

100.0%

Below, we will address the
costs of unprofitable customer relationships and suggest strategies you can put
in place in your business to improve profitability and begin to implement a
"fewer and deeper" strategy for growth.

The Cost of Unprofitable
Customers

There
are several reasons why managers pursue unprofitable customers. One of the
biggest we have found is the passion that many middle-market company managers
and business owners have for selling. These managers often place a premium on
attracting new customers and generating top line revenue growth. This passion
for the top line may be rooted in a fear of not having enough customers should
there be a business downturn. This approach can lead companies in a wrong and
unprofitable direction. If managers do not focus efforts on the right
(profitable) customers, the same passion that was a driver in building the
business can become a downright anchor, dragging down profitability.

An
in-depth analysis of one client company revealed net profit would be two and a
half times higher without 65% of its customers! This client provided a striking
example of the cost of unprofitable customers. This manufacturing company
provided excellent service and, as a result, continued to expand its number of
customers over the years. Each year they added customers and seldom, if ever,
lost a customer. Unfortunately, 65% of their customers made up a paltry 5% of
total revenue. To make matters worse, these small customers were the most
frequent buyers of the company's most unprofitable product lines. A detailed
analysis revealed the company's net profit would be two and half times higher
without 65% of its customers! We did not advocate "firing" these
customers but rather provided a procedd to improve profitability which we will
cover in the next article in this series.

Some of
the failure to focus on more profitable customers comes from inadequate
accounting. Companies, large and small, struggle with how to measure customer
net profitability accurately. In many companies, management may know how much
gross profit they are generating from each customer. The problem often occurs
in the costs that occur after gross margin. The resources it takes to sell,
administer, and service customers makes the issue of real profitability more
complicated. For example, consider the customer with a relatively small level
of sales but a healthy gross margin in both percentage and absolute terms. This
customer buys frequently (lots of invoices), has high service requirements
(always orders at the last minute and expects overnight delivery), and
stretches payment terms to 120 days. This may not be a truly profitable
customer. On the other extreme, it could be a large customer who purchases a
significant volume and has a gross margin that is relatively lower as a
percentage of revenue. This customer purchases in larger quantities (fewer
invoices), has reasonable service demands (does not order at the last minute),
and pays in a reasonable amount of time. Which one is the more profitable and
more desirable customer? This is a question that is too infrequently asked in
many companies because such "below-the-line" costs are not known.

Opportunity
cost - time with marginal customers versus time with high potential customers. Even if
you are confident that you can accurately determine customer profitability,
there is an additional factor to consider - opportunity cost. What is the
opportunity cost of having a salesperson travel to see a marginal customer
versus spending time with top priority customers and prospects? Costs such as
these make the bottom quartile of your customer base even less profitable than
you may realize. These relationships not only result in poor customer
profitability, but can also be a detriment to other existing and prospective
customer relationships. Executing a "fewer and deeper" strategy
requires you to focus your resources on relationships that matter.

Welcome to Mead's Issues for Growth

Since 1991, we have been publishing a periodic eLetter "Issues for Growth" that contains articles or thoughts of interest to business owners looking to grow and improve their businesses. We invite your comments and discussion.

About Me

We have been consulting with small and mid-size businesses for over 30 years, helping companies move to the "next level of success" by focusing on strategies that the company can execute well and aligning all activities within the company to those key strategies.
I have started and run 7 companies - a couple of great successes, a few moderate successes, a couple of screaming failures.